Published on Nov 30, 2023
The term " Derivative " indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else.
In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.
With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act , as:-
A Derivative includes: -
• a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
• a contract which derives its value from the prices, or index of prices, of underlying securities;
Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.
Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.
Under Securities Contracts (Regulations) Act,1956 options on securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;
An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.
Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame.
Cash settlement amount, settlement currency and exercise Settlement value
The cash settlement amount is the amount of cash that the holder of a cash-settled option is entitled to receive upon exercise. It is the amount by which the exercise settlement value of the underlying interest of a cash-settled call exceeds the exercise price, or the amount by which the exercise price of a cash-settled put exceeds the exercise settlement value of the underlying interest, multiplied by the multiplier for the option.
EXAMPLE: Assume that a holder of a cash-settled call on the XYZ index that has an exercise rice of 80 exercises it when the exercise settlement value of the index is 85. If the multiplier for XYZ index options is 100, the assigned writer would be obligated to pay, and the exercising holder would be entitled to receive, a cash settlement amount of $500 ($85 minus $80 multiplied by 100=$500).
The currency in which the cash settlement amount is payable is called the settlement currency. The settlement currency for all cash-settled options with standardized terms that are trading at the date of this booklet is U.S. dollars. It is possible that another currency will be the settlement currency for some options introduced in the future.
The manner of determining the exercise settlement value for a particular option series is fixed by the options market on which the series is traded. The exercise settlement values for options on a particular underlying interest traded in one options market will not necessarily be determined in the same manner as the exercise settlement values for options or futures on the same underlying interest that may be traded in other markets.
Options markets may change the method of determining exercise settlement values for particular options series on specified days or on all days. These changes may be made applicable to series outstanding at the time the changes become effective. Alternatively, an options market might phase in a change in the method of determining exercise settlement values by opening new series of options identical to outstanding series in all respects other than the method for calculating exercise settlement values. Such new series would trade alongside the old series until both series expire, but the two series would not be interchangeable. In the future, options markets may, subject to regulatory approval, introduce options whose exercise settlement values may not exceed a specified maximum amount.
The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. It is the price set by the holder and writer, or their brokers, in a transaction in an options market where the option is traded. It is not a standardized term of the option. The premium does not constitute a "down-payment." It is simply and entirely a non-refundable payment in full-from the option holder to the option writer-for the rights conveyed by the option. The premium is not fixed by the options markets.
Premiums are subject to continuous change in response to market and economic forces, including changes in the trading conditions on the markets where the particular options are traded. The factors which may generally affect the pricing of an option include such variables as the current value of the underlying interest and the relationship between that value and the exercise price, the current values of related interests (e.g., futures on the underlying interest or other interests related to the underlying interest), the style of the option, the individual estimates of market participants of the future volatility of the underlying interest, the historical volatility of the underlying interest, the amount of time remaining until expiration, cash dividends payable on the underlying stock (in the case of stock and stock index options), current interest rates, current currency exchange rates (in the cases of foreign currency options and options whose premiums or cash settlement amounts are payable in a foreign currency), the depth of the market for the option, the effect of supply and demand in the options market as well as in the markets for the underlying interest and for related interests, the information then available about current prices and operations in the markets for the underlying interest and related interests, the individual estimates of market participants of future developments that might affect any of the foregoing, and other factors generally affecting the prices or volatility of options, underlying interests, related interests or securities generally. Also see the discussion below of "Intrinsic Value and Time Value."
Readers should not assume that options premiums will necessarily conform or correlate with any theoretical options pricing formula, chart, last sale, or the prices of the underlying interest, related interests or other options at any particular time. The currency in which the premium is payable is called the premium currency. The premium currency for most options is U.S. dollars. However, the premium currency for cross-rate foreign currency options is a foreign currency, and other options with premiums payable in a foreign currency may be introduced after the date of this booklet.
It is sometimes useful to consider the premium of an option as consisting of two components: intrinsic value and time value. Intrinsic value reflects the amount, if any, by which an option is in the money. Time value is whatever the premium of the option is in addition to its intrinsic value. An American-style option may ordinarily be expected to trade for no less than its intrinsic value prior to its expiration, although occasionally an American-style option will trade at less than its intrinsic value. Because European-style and capped options are not exercisable at all times, they are more likely than American-style options to trade at less than their intrinsic value when they are not exercisable.
EXAMPLE OF A CALL WITH INTRINSIC VALUE: At a time when the current market price of XYZ stock is $46 a share, an XYZ 40 call would have an intrinsic value of $6 a share. If the market price of the stock were to decline to $44, the intrinsic value of the call would be only $4. Should the price of the stock drop to $40 or below, the call would no longer have any intrinsic value.
EXAMPLE OF A PUT WITH INTRINSIC VALUE: At a time when the current market price of XYZ stock is $46 a share, an XYZ 50 put would have an intrinsic value of $4 a share. Were the market price of XYZ stock to increase to $50 or above, the put would no longer have any intrinsic value.
Index Futures and Index Option Contracts
Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index.
Similarly, the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.
An index, in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectoral indices.
In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the index has begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be discontinued.
By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry.
Reference: SEBI & Characteristics and Risks of Standardized Options ©1994
